Pros and Cons in Binary Options

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A Guide to Trading Binary Options in the U.S.

Binary options are financial options that come with one of two payoff options: a fixed amount or nothing at all. That’s why they’re called binary options—because there is no other settlement possible. The premise behind a binary option is a simple yes or no proposition: Will an underlying asset be above a certain price at a certain time?

Traders place trades based on whether they believe the answer is yes or no, making it one of the simplest financial assets to trade. This simplicity has resulted in broad appeal among traders and newcomers to the financial markets. As simple as it may seem, traders should fully understand how binary options work, what markets and time frames they can trade with binary options, advantages, and disadvantages of these products, and which companies are legally authorized to provide binary options to U.S. residents.

Binary options traded outside the U.S. are typically structured differently than binaries available on U.S. exchanges. When considering speculating or hedging, binary options are an alternative—but only if the trader fully understands the two potential outcomes of these exotic options.

Now that you know some of the basics, read on to find out more about binary options, how they operate, and how you can trade them in the United States.

U.S. Binary Options Explained

Binary options provide a way to trade markets with capped risk and capped profit potential, based on a yes or no proposition.

Let’s take the following question as an example: Will the price of gold be above $1,250 at 1:30 p.m. today?

If you believe it will be, you buy the binary option. If you think gold will be below $1,250 at 1:30 p.m., then you sell this binary option. The price of a binary option is always between $0 and $100, and just like other financial markets, there is a bid and ask price.

The above binary may be trading at $42.50 (bid) and $44.50 (offer) at 1 p.m. If you buy the binary option right then, you will pay $44.50. If you decide to sell right then, you’ll sell at $42.50.

Let’s assume you decide to buy at $44.50. If at 1:30 p.m. the price of gold is above $1,250, your option expires and it becomes worth $100. You make a profit of $100—$44.50 = $55.50 (minus fees). This is called being in the money. But if the price of gold is below $1,250 at 1:30 p.m., the option expires at $0. Therefore you lose the $44.50 invested. This called out of the money.

The bid and offer fluctuate until the option expires. You can close your position at any time before expiry to lock in a profit or a reduce a loss, compared to letting it expire out of the money.

A Zero-Sum Game

Eventually, every option settles at $100 or $0—$100 if the binary option proposition is true and $0 if it turns out to be false. Thus, each binary option has a total value potential of $100, and it is a zero-sum game—what you make, someone else loses, and what you lose, someone else makes.

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Each trader must put up the capital for their side of the trade. In the examples above, you purchased an option at $44.50, and someone sold you that option. Your maximum risk is $44.50 if the option settles at $0, and so the trade costs you $44.50. The person who sold to you has a maximum risk of $55.50 if the option settles at $100—$100 – $44.50 = $55.50.

A trader may purchase multiple contracts if desired. Here’s another example:

  • NASDAQ US Tech 100 index > $3,784 (11 a.m.).

The current bid and offer are $74.00 and $80.00, respectively. If you think the index will be above $3,784 at 11 a.m., you buy the binary option at $80, or place a bid at a lower price and hope someone sells to you at that price. If you think the index will be below $3,784 at that time, you sell at $74.00, or place an offer above that price and hope someone buys it from you.

You decide to sell at $74.00, believing the index is going to fall below $3,784 (called the strike price) by 11 a.m. And if you really like the trade, you can sell (or buy) multiple contracts.

Figure 1 shows a trade to sell five contracts (size) at $74.00. The Nadex platform automatically calculates your maximum loss and gain when you create an order, called a ticket.

Nadex Trade Ticket with Max Profit and Max Loss (Figure 1)

Binary Options Basics

Binary Options Types, Pros and Cons

Binary options have become very popular investment tool, perhaps due to how simple they seem to be. The name ‘binary’ hints at the fact that traders are presented with two choices. This makes them seem easy to understand, which is part of the reason why traders with fewer skills like them.

The idea is that you are predicting on which way prices in various global markets will go in a specified period of time. If you guess correctly then you claim your profit, and if you guess incorrectly, you lose your stake. That’s it!

Binary Options Basics – What are They?

One of the binary options basics you need to be aware of is that the type you’ll see traded most often is called a high-low or fixed-return option, which lets you wager on the movements of stocks, indices, commodities and foreign exchange. These options expire at a predetermined date, time and strike price. If a trader bets correctly on the market’s direction and the final price when the deal expires, they get paid a fixed amount. It doesn’t matter if the instrument has moved a little or a lot since the trade was opened, it just counts as a win, and the trader still receives that same amount. If they get it wrong, they lose their original stake.

So, you see how simple life as a binary options trader appears to be? You’re betting that a stock, index, commodity or currency pair is going to go one way or the other. If you think your asset or index is going to go up, you take what’s called a “call.” If you think it’s going to drop, then you take what’s called a “put.” A call makes money when the instrument is trading higher than the strike price. A put makes money when the instrument is trading lower than the strike price when the deal expires. The broker lets you know what the strike price, expiration date, payout, and risk are when the trade is first set up. With the majority of high-low binary options traded beyond US borders, the strike price is usually the current market price of the asset or index.

US Binary Options vs. Overseas Binary Options

In countries outside the US, binary options usually pay out a set amount and bring a set level of risk. It’s also brokers who offer them directly instead of an exchange. The brokers make their money by taking in more on losing trades than they pay out on winning trades. Apart from certain exceptions, these financial instruments will usually be held until the date of expiry.

US Binary options listings were first made available by the Chicago Board Options Exchange (CBOE) in 2008, which is regulated by the SEC.

These options can be traded at any time, with the rate sitting somewhere between one and a hundred, depending on how likely each one is to make or lose money. On-screen, the trader sees a totally transparent deal and is free to cut their losses or walk away with their profits before the expiry time if they want to.

A trader may also choose to enter while the rate is fluctuating, in order to take advantage of different risk-to-reward situations, or hold until the trade expires, closing the position at the highest amount of gain or loss as compared to what it was when they entered.

Since US binary options are traded on an exchange, this means that every trade takes place between a buyer and a seller who are willing to enter into this arrangement with each other. To make its money the exchange adds a fee that matches counter-parties.

Example of a High-Low Option

In this example, you believe that the NASDAQ index will rally for the duration of the trading day, so you purchase an index call option. The index is currently trading at 1,700, so you’re betting that when your trade expires it will be sitting at a higher number. You have a huge amount of choice when it comes to selecting when you want that expiration time to be. You could choose minutes away, or you could settle for months. It all depends on what your analysis points to. If it suggests that 30 minutes from now would be the best time, then you can choose that. This ‘for example’ deal will pay out 60% on top of your original stake if the NASDAQ rises above 1,800 at that time. If it drops to less than that then you will lose your stake. Minimum and maximum stakes vary from broker to broker.

Let’s say you invest $100 in the call. Expiration is in 30 minutes. The NASDAQ price at expiration is where the clock stops and determines whether you win or lose. The price at expiration could be the last quoted price, or the (bid+ask)/2. Every broker will have their own price rules about expiration.

With this example, we’re assuming that the last quote on the NASDAQ before expiration was 1,703, which means you get a $120 profit (because that’s 60% of $200). You also get your original $200 investment back as well. But if the price at expiration had been 1699 you would kiss your original $200 goodbye.

In the event that the price on expiration is exactly the same as the strike price, the trader usually gets their money back, although you should check with individual brokers to be sure of what their rules are. Any profits that you make will be added to your trader count automatically as soon as the position is closed.

Other Types of Binary Options

This example is for a typical high-low binary option—the most often traded binary option outside the US, but international brokers will usually offer a whole host of other types of binaries too. Here are two examples:

  • “one-touch” options. The asset you’re trading needs to hit the strike price only once before expiration to make you some money. Targets are set above and below the present price, so traders can pick which one they think the price will hit before the expiration date and time.
  • “range” options. The trader defines a price range that the asset will trade inside until expiry. You win if the price doesn’t step outside this range. You lose if it does.

With a lot of brokers competing in the binary options arena, some have taken to offering products that give payouts between 40% and 400%. Many will have different structures and requirements, but you’ll always know the elements of risk and reward before you embark upon the trade. This potentially means you can make a lot of money from your investment, but brokers don’t give money away, so with such big headline figures, chances are you won’t.

In contrast to US binary option brokers, there are some foreign brokers who will permit traders to exit positions before they expire, but most don’t. Doing this before a position expires usually means the broker won’t pay out as much, or you’ll suffer a modest loss, but not have to give up the whole investment.

The Pros and Cons of Binary Options

You’ll always know the risk and reward ahead of time, which eliminates a huge amount of doubt. And you’ll always know how much you’re going to win or lose because both amounts are fixed. No trader likes unforeseen surprises, so this is a big plus for this kind of trading. Another one is the fact that there are often no fees or commissions to be paid.

Simplicity is obviously a factor because you’re essentially tossing a coin and placing a wager on heads or tails. The asset either goes up or it goes down.

You also don’t need to worry about liquidity, because as a trader you won’t be taking ownership of any underlying asset.

Brokers can offer endless strike prices and expiration times and dates, so there are lots of choices. It’s also worth bearing in mind that at any time of the day or night market is open somewhere doing a roaring trade in many different asset classes..

Trading Guide: Pros and Cons of Trading Long-Term Binary Options

Long-term binary options may sound an oxymoron, which is why so few offer them. But with some space for analysis

You may know long-term trading by its more common term-investing, a term which is somewhat stranger to the binary options space when thinking about 5 or even 1 minutes expiry options.

Binary options were devised with the idea of exploiting the smallest movements in the market, so it may seem illogical to trade them long-term. However, the same logic makes them more predictable and safer for long-term assumptions, especially for brokers who offer the close before expiry feature.

Consider, for example, trading a yearly Google option that will expire in 10 months. You can wait for Google’s quarterly earnings reports and periodic news announcements, constantly keeping up with the company’s chart to see where they are heading. Such an outlook can provide more data and help in trying to analyze the company’s performance for several months, before the option is no longer available for trading.

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Another important fact is the ability to curb the emotional factor. It is well known that emotions may affect and even harm traders’ decisions, and opting for longer term options leave a smaller room for the “exciting” nature of the intraday binary options trading.

On the other hand, this means that the traders of longer terms options are unable to react to market developments and take advantage of them, as their funds are locked until the expiry.

There are some brokers who offer long-term touch options that can prove useful in situations like this, but they carry an additional amount of risk as well.

Trading long-term binary options is not necessarily better or worse than shorter ones. We can compare the two instruments to a fancy convertible sport car and a sturdy 4×4 vehicle: It does not matter which one you choose, as long as it drives you home.

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